Common Stocks as a Hedge against Inflation

THIS PAPER DEFINES the effectiveness of common stocks as an inflation hedge as the extent to which they can be used to reduce the risk of an investor's real return which stems from uncertainty about the future level of the prices of consumption goods.' Since there is one type of security whose real return is certain but for inflation risk, namely single-period2, riskless-in-terms-of-default nominal bonds, it seems appropriate to identify inflation risk with the variance of the real return on such a bond. Accordingly, we measure the effectiveness of common stocks as an inflation hedge as the proportional reduction in that variance attainable by combining a "representative" well-diversified portfolio of common stocks and the nominal bond in their variance minimizing proportions. It is worthwhile to indicate the relationship between this view of hedging against inflation and the investor's ultimate objective of optimal portfolio selection. This can best be done in the framework of the Markowitz-Tobin-mean-variance model of portfolio choice.3 In that model the process of portfolio selection is divided into two separate stages: (1) identification of the efficient portfolio frontier and (2) choosing the optimal portfolio on that frontier. This paper focuses on one particular point on the efficient frontier-the minimum variance portfolio. From this perspective hedging against inflation is essentially the process of taking a risk-free-in-terms-of-default nominal bond as the starting point and using other securities to eliminate as much of the variance of its real return as possible. We define the difference between the mean real return on a nominal bond and the mean real return on the minimum variance portfolio as the "cost" of hedging